FOREIGN EXCHANGE MARKETS

Learning Objectives

By the end of this section, you will be able to:

 Explain supply and demand for exchange rates

 Define arbitrage
 Explain purchasing power parity’s importance when comparing countries.

The foreign exchange market involves firms, households, and investors who demand
and supply currencies coming together through their banks and the key foreign
exchange dealers. Figure 1 (a) offers an example for the exchange rate between the
U.S. dollar and the Mexican peso. The vertical axis shows the exchange rate for U.S.
dollars, which in this case is measured in pesos. The horizontal axis shows the
quantity of U.S. dollars being traded in the foreign exchange market each day. The
demand curve (D) for U.S. dollars intersects with the supply curve (S) of U.S. dollars
at the equilibrium point (E), which is an exchange rate of 10 pesos per dollar and a
total volume of $8.5 billion.

Figure 1. Demand and Supply for the U.S. Dollar and Mexican Peso Exchange Rate.
(a) The quantity measured on the horizontal axis is in U.S. dollars, and the exchange
rate on the vertical axis is the price of U.S. dollars measured in Mexican pesos. (b)
The quantity measured on the horizontal axis is in Mexican pesos, while the price on
the vertical axis is the price of pesos measured in U.S. dollars. In both graphs, the
equilibrium exchange rate occurs at point E, at the intersection of the demand curve
(D) and the supply curve (S).
Figure 1 (b) presents the same demand and supply information from the perspective of
the Mexican peso. The vertical axis shows the exchange rate for Mexican pesos,
which is measured in U.S. dollars. The horizontal axis shows the quantity of Mexican
pesos traded in the foreign exchange market. The demand curve (D) for Mexican
pesos intersects with the supply curve (S) of Mexican pesos at the equilibrium point
(E), which is an exchange rate of 10 cents in U.S. currency for each Mexican peso and
a total volume of 85 billion pesos. Note that the two exchange rates are inverses: 10
pesos per dollar is the same as 10 cents per peso (or $0.10 per peso). In the actual
foreign exchange market, almost all of the trading for Mexican pesos is done for U.S.
dollars. What factors would cause the demand or supply to shift, thus leading to a
change in the equilibrium exchange rate? The answer to this question is discussed in
the following section.

EXPECTATIONS ABOUT FUTURE

EXCHANGE RATES
One reason to demand a currency on the foreign exchange market is the belief that the
value of the currency is about to increase. One reason to supply a currency—that is,
sell it on the foreign exchange market—is the expectation that the value of the
currency is about to decline. For example, imagine that a leading business newspaper,
like the Wall Street Journal or the Financial Times, runs an article predicting that the
Mexican peso will appreciate in value. The likely effects of such an article are
illustrated in Figure 2. Demand for the Mexican peso shifts to the right, from D 0 to D1,
as investors become eager to purchase pesos. Conversely, the supply of pesos shifts to
the left, from S0 to S1, because investors will be less willing to give them up. The
result is that the equilibrium exchange rate rises from 10 cents/peso to 12 cents/peso
and the equilibrium exchange rate rises from 85 billion to 90 billion pesos as the
equilibrium moves from E0 to E1.
Figure 2. Exchange Rate Market for Mexican Peso Reacts to Expectations about
Future Exchange Rates. An announcement that the peso exchange rate is likely to
strengthen in the future will lead to greater demand for the peso in the present from
investors who wish to benefit from the appreciation. Similarly, it will make investors
less likely to supply pesos to the foreign exchange market. Both the shift of demand to
the right and the shift of supply to the left cause an immediate appreciation in the
exchange rate.

Figure 2.  also illustrates some peculiar traits of supply and demand diagrams in the
foreign exchange market. In contrast to all the other cases of supply and demand you
have considered, in the foreign exchange market, supply and demand typically both
move at the same time. Groups of participants in the foreign exchange market like
firms and investors include some who are buyers and some who are sellers. An
expectation of a future shift in the exchange rate affects both buyers and sellers—that
is, it affects both demand and supply for a currency.

The shifts in demand and supply curves both cause the exchange rate to shift in the
same direction; in this example, they both make the peso exchange rate stronger.
However, the shifts in demand and supply work in opposing directions on the quantity
traded. In this example, the rising demand for pesos is causing the quantity to rise
while the falling supply of pesos is causing quantity to fall. In this specific example,
the result is a higher quantity. But in other cases, the result could be that quantity
remains unchanged or declines.

This example also helps to explain why exchange rates often move quite substantially
in a short period of a few weeks or months. When investors expect a country’s
currency to strengthen in the future, they buy the currency and cause it to appreciate
immediately. The appreciation of the currency can lead other investors to believe that
future appreciation is likely—and thus lead to even further appreciation. Similarly, a
fear that a currency might weaken quickly leads to an actual weakening of the
currency, which often reinforces the belief that the currency is going to weaken
further. Thus, beliefs about the future path of exchange rates can be self-reinforcing,
at least for a time, and a large share of the trading in foreign exchange markets
involves dealers trying to outguess each other on what direction exchange rates will
move next.

DIFFERENCES ACROSS COUNTRIES IN

RATES OF RETURN
The motivation for investment, whether domestic or foreign, is to earn a return. If
rates of return in a country look relatively high, then that country will tend to attract
funds from abroad. Conversely, if rates of return in a country look relatively low, then
funds will tend to flee to other economies. Changes in the expected rate of return will
shift demand and supply for a currency. For example, imagine that interest rates rise
in the United States as compared with Mexico. Thus, financial investments in the
United States promise a higher return than they previously did. As a result, more
investors will demand U.S. dollars so that they can buy interest-bearing assets and
fewer investors will be willing to supply U.S. dollars to foreign exchange markets.
Demand for the U.S. dollar will shift to the right, from D 0 to D1, and supply will shift
to the left, from S0 to S1, as shown in Figure 3. The new equilibrium (E1), will occur at
an exchange rate of nine pesos/dollar and the same quantity of $8.5 billion. Thus, a
higher interest rate or rate of return relative to other countries leads a nation’s
currency to appreciate or strengthen, and a lower interest rate relative to other
countries leads a nation’s currency to depreciate or weaken. Since a nation’s central
bank can use monetary policy to affect its interest rates, a central bank can also cause
changes in exchange rates—a connection that will be discussed in more detail later in
this chapter.
Figure 3. Exchange Rate Market for U.S. Dollars Reacts to Higher Interest Rates. A
higher rate of return for U.S. dollars makes holding dollars more attractive. Thus, the
demand for dollars in the foreign exchange market shifts to the right, from D 0 to D1,
while the supply of dollars shifts to the left, from S 0 to S1. The new equilibrium (E1)
has a stronger exchange rate than the original equilibrium (E 0), but in this example, the
equilibrium quantity traded does not change.
RELATIVE INFLATION
If a country experiences a relatively high inflation rate compared with other
economies, then the buying power of its currency is eroding, which will tend to
discourage anyone from wanting to acquire or to hold the currency. Figure 4 shows an
example based on an actual episode concerning the Mexican peso. In 1986–87,
Mexico experienced an inflation rate of over 200%. Not surprisingly, as inflation
dramatically decreased the purchasing power of the peso in Mexico, the exchange rate
value of the peso declined as well. As shown in Figure 4, demand for the peso on
foreign exchange markets decreased from D 0 to D1, while supply of the peso increased
from S0 to S1. The equilibrium exchange rate fell from $2.50 per peso at the original
equilibrium (E0) to $0.50 per peso at the new equilibrium (E1). In this example, the
quantity of pesos traded on foreign exchange markets remained the same, even as the
exchange rate shifted.
Figure 4. Exchange Rate Markets React to Higher Inflation. If a currency is
experiencing relatively high inflation, then its buying power is decreasing and
international investors will be less eager to hold it. Thus, a rise in inflation in the
Mexican peso would lead demand to shift from D0 to D1, and supply to increase from
S0 to S1. Both movements in demand and supply would cause the currency to
depreciate. The effect on the quantity traded is drawn here as a decrease, but in truth it
could be an increase or no change, depending on the actual movements of demand and
supply.
PURCHASING POWER PARITY
Over the long term, exchange rates must bear some relationship to the buying power
of the currency in terms of goods that are internationally traded. If at a certain
exchange rate it was much cheaper to buy internationally traded goods—such as oil,
steel, computers, and cars—in one country than in another country, businesses would
start buying in the cheap country, selling in other countries, and pocketing the profits.

For example, if a U.S. dollar is worth $1.60 in Canadian currency, then a car that sells
for $20,000 in the United States should sell for $32,000 in Canada. If the price of cars
in Canada was much lower than $32,000, then at least some U.S. car-buyers would
convert their U.S. dollars to Canadian dollars and buy their cars in Canada. If the price
of cars was much higher than $32,000 in this example, then at least some Canadian
buyers would convert their Canadian dollars to U.S. dollars and go to the United
States to purchase their cars. This is known as arbitrage, the process of buying and
selling goods or currencies across international borders at a profit. It may occur
slowly, but over time, it will force prices and exchange rates to align so that the price
of internationally traded goods is similar in all countries.

The exchange rate that equalizes the prices of internationally traded goods across
countries is called the purchasing power parity (PPP) exchange rate. A group of
economists at the International Comparison Program, run by the World Bank, have
calculated the PPP exchange rate for all countries, based on detailed studies of the
prices and quantities of internationally tradable goods.

The purchasing power parity exchange rate has two functions. First, PPP exchange
rates are often used for international comparison of GDP and other economic
statistics. Imagine that you are preparing a table showing the size of GDP in many
countries in several recent years, and for ease of comparison, you are converting all
the values into U.S. dollars. When you insert the value for Japan, you need to use a
yen/dollar exchange rate. But should you use the market exchange rate or the PPP
exchange rate? Market exchange rates bounce around. In summer 2008, the exchange
rate was 108 yen/dollar, but in late 2009 the U.S. dollar exchange rate versus the yen
was 90 yen/dollar. For simplicity, say that Japan’s GDP was ¥500 trillion in both 2008
and 2009. If you use the market exchange rates, then Japan’s GDP will be $4.6 trillion
in 2008 (that is, ¥500 trillion /(¥108/dollar)) and $5.5 trillion in 2009 (that is, ¥500
trillion /(¥90/dollar)).

Of course, it is not true that Japan’s economy increased enormously in 2009—in fact,
Japan had a recession like much of the rest of the world. The misleading appearance
of a booming Japanese economy occurs only because we used the market exchange
rate, which often has short-run rises and falls. However, PPP exchange rates stay
fairly constant and change only modestly, if at all, from year to year.

The second function of PPP is that exchanges rates will often get closer and closer to
it as time passes. It is true that in the short run and medium run, as exchange rates
adjust to relative inflation rates, rates of return, and to expectations about how interest
rates and inflation will shift, the exchange rates will often move away from the PPP
exchange rate for a time. But, knowing the PPP will allow you to track and predict
exchange rate relationships.

KEY CONCEPTS AND SUMMARY

In the extreme short run, ranging from a few minutes to a few weeks, exchange rates
are influenced by speculators who are trying to invest in currencies that will grow
stronger, and to sell currencies that will grow weaker. Such speculation can create a
self-fulfilling prophecy, at least for a time, where an expected appreciation leads to a
stronger currency and vice versa. In the relatively short run, exchange rate markets are
influenced by differences in rates of return. Countries with relatively high real rates of
return (for example, high interest rates) will tend to experience stronger currencies as
they attract money from abroad, while countries with relatively low rates of return
will tend to experience weaker exchange rates as investors convert to other currencies.

In the medium run of a few months or a few years, exchange rate markets are
influenced by inflation rates. Countries with relatively high inflation will tend to
experience less demand for their currency than countries with lower inflation, and
thus currency depreciation. Over long periods of many years, exchange rates tend to
adjust toward the purchasing power parity (PPP) rate, which is the exchange rate such
that the prices of internationally tradable goods in different countries, when converted
at the PPP exchange rate to a common currency, are similar in all economies.